Todd D. Kravet

A New Measure of Accounting Quality

This study develops a measure of accounting quality based on audit fees. Adopting a neoclassical view of the audit market, we argue that unexplained audit fees should contain information about accounting quality. We find that our measure of unexplained audit fees correlates positively with other empirical measures of quality. We further show that our measure of accounting quality is incrementally predictive of fraud, restatements, and SEC comment letters, controlling for other measures of quality. Overall, we believe that the information in audit fees can be used to provide an alternative measure of a firm’s accounting quality.

Financial Statement Comparability and the Efficiency of Acquisition Decisions

This study examines whether acquirers make better acquisition decisions when target firms’ financial statements exhibit greater comparability with industry peer firms. We predict and find that acquirers’ make more profitable acquisition decisions when targets’ financial statements are more comparable—as evidenced by higher merger announcement returns, higher acquisition synergies, and better future operating performance. We also find that post-acquisition goodwill impairments and post-acquisition divestitures are less likely when target firms’ financial statements are more comparable. Finally, we find the effect of targets’ comparability is more pronounced when acquirers’ ex-ante information asymmetry is higher and when acquisitions are accomplished via tender offers to target shareholders. In total, our evidence suggests targets’ financial statement comparability helps acquirers make better acquisitioninvestment decisions and fosters more efficient capital allocation. We thank Ted Goodman (FARS discussant), Dan Wangerin (AAA discussant), workshop participants at the 2013 AAA Annual Meeting, the 2014 FARS Midyear Meeting, the 2013 BYU Accounting Research Symposium, the University of Iowa, Duke University, University of Minnesota Research Conference and Penn State University for their helpful comments and suggestions. We also thank the University of Texas at Austin Capital Markets Readings Group for their helpful comments and suggestions. Finally, we thank Rodrigo Verdi for providing the SAS program for comparability measures. The authors acknowledge funding from the Tippie College of Business and Naveen Jindal School of Management.

Why Do Firms Defer Internal Control Assessments and Does It Matter? Evidence from M&A Transactions

To inform the debate on the merits of internal control audits, we examine managers’ decisions to temporarily exempt newly acquired businesses from Section 404 of the Sarbanes-Oxley Act. We provide evidence that managers are more likely to elect the exemption when expected compliance costs are higher, such as when acquisitions are larger and occur later in the year. We find only modest evidence that managers use the exemption to avoid scrutiny of value-destroying deals. Exemption use, however, is associated with negative post-acquisition outcomes, including lower return-on-assets and higher likelihoods of goodwill impairments and financial statement restatements. These results are consistent with compliance providing benefits by facilitating timely identification and correction of control problems in the newly acquired business. Finally, we document negative abnormal stock returns at the time exemption use is announced and over the subsequent three years, suggesting that investors view exemption use negatively and that their initial price reactions are incomplete.

The Effect of SFAS 141 and 142 on the Likelihood and the Form of Financing of Corporate Takeovers

We investigate the effects of the elimination of the pooling method, under SFAS 141, and of goodwill amortization, under SFAS 142, on the form of acquisition financing and on a firm’s takeover probability. We find that before these accounting rules, target firms’ step-up value is positively associated with the probability of using stock-for-stock as against partial stock financing. Afterwards, this association decreases significantly and is indistinguishable from zero. These results suggest that the pooling method of accounting is a significant determinant of the form of acquisition financing. These rules also led to a greater decrease in takeover probability for firms with larger predicted step-up values, and this effect is less pronounced for firms with more of the predicted step-up value made up of goodwill. These results suggest that both the pooling method and the method for goodwill amortization are significant determinants of takeover probability. Overall, the study uses a natural experiment to provide a novel finding that certain acquisition related accounting methods significantly influence the form of acquisition financing and takeover probability.We investigate the effects of accounting rule changes that eliminate the pooling method (SFAS 141) and goodwill amortization (SFAS 142) on the form of acquisition financing and on a firm’s takeover probability. The primary requirement to qualify for the pooling method is structuring the transaction as a stock-for-stock exchange. We find that before the new accounting rules, target firms’ step-up value is positively associated with the probability of using stock-for-stock as against partial stock financing. After the new rules, this association decreases significantly and is indistinguishable from zero. These results suggest that in the pre SFAS 141 period, greater use of stock-for-stock exchanges for target firms with larger step-up values was motivated by the favorable effect of the pooling method on the reported income of the acquirer, and this motivation to use stock-for-stock exchanges goes away with the elimination of the pooling method. The new rules also resulted in a greater decrease in takeover probability for firms with larger step-up values than for firms with smaller step-up values, presumably due to the elimination of the pooling method. When the step-up value of a firm is composed primarily of goodwill, the above effect is attenuated, consistent with the elimination of goodwill amortization. Overall, the study uses a natural experiment to provide a novel finding that accounting methods have significant effects on the form of acquisition financing and on takeover probability. We appreciate the helpful comments of Jarrad Harford, Bob Holthausen, and workshop participants at Hong Kong University of Science and Technology, London Business School, London School of Economics, State University of New York at Buffalo, and the University of Houston.